The SBIR Tipping Point - Can There Be Too Much Venture Investment?

It is no secret that investors often desire companies that have a nice flow of Small Business Innovation and Research (SBIR) program grant revenue. After all, there are few better ways to advance a technology without raising dilutive additional capital.

SBIR is a U.S. government program intended to help fund specific small businesses that conduct research and development.

Despite some radical changes in the law in 2012, investors still must be mindful that investment limits can apply, and the cost of exceeding the limit is high.

Recently, it came as a most unwelcome surprise to a venture-backed company and its investors that, as a result of a follow-on investment that had the effect of changing majority ownership from the founders to venture firms, the company had to forfeit an SBIR award that it had just won.

To better understand their surprise, consider the following:

The venture capital industry and entrepreneurs alike celebrated a most joyful New Year’s Eve on December 31, 2011 as President Obama signed into law the National Defense Authorization Act for Fiscal Year 2012. As one part of that Act, the long standing prohibition on awarding SBIR grants to venture capital controlled companies was relaxed, and new law emerged. For the first time, companies that were majority owned by venture capital firms were eligible to compete as a small business for contract awards under the SBIR program.

As it subsequently played out, the new law permitted agencies to elect what became known as “Section 5107 Authority”—the authority to grant SBIR awards to companies where majority control was held by venture capital operating companies—just as long as no single venture capital company owned more than 51% of the company.

But there was a little problem. While some agencies embraced Section 5107 Authority, others rejected it. And of those that exercised the authority, they could only do it with a portion of their SBIR budget. So, some SBIR awards continued to follow the same old path—the only eligible companies were those where majority ownership was held by the founders or other individuals.

And so that brings us to the current problem—it is often not clear what agencies will exercise the authority and what agencies won’t—and for those that do, what programs and awards are covered. For example, if you examine the National Institutes of Health (NIH) website for SBIR eligibility, and compare that to the National Science Foundation SBIR program eligibility requirements, you won’t come out in the same place. The former contemplates Section 5107 awards, the latter does not.

So if you are thinking of investing in a small business that has a portfolio of SBIR awards, and if you are a venture capital operating company, a hedge fund or a private equity firm, you would be well served to check out the eligibility requirements of the company’s SBIR award portfolio. Because if the effect of your investment is to tip the balance of ownership in favor of the investors, you may have just wiped out a stream of nutritious revenue. And nobody wants that.

Have questions or want to chat about this some more, please comment below, email me or connect with me on LinkedIn.